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In Boltar LLC et al v. Commissioner, 136 T.C. No. 14 (4/15/2011) the Tax Court granted the government’s motion in limine, which motion was timely submitted pre-trial, to strike the admission of the taxpayer’s experts’ report into evidence at trial based on its argument that the report was “unrealiable and irrelevant” under FREV 702 and the Supreme Court’s landmark decision in Daubert v. Merrell Dow Pharmaceutical, Inc., 509 U.S. 579 (1993). The Court , in a fully reviewed decision, sustained the government’s motion in limine and excluded the taxpayer’s expert report from evidence and then agreed with the IRS’s expert’s determination of the value of the conservation easement . The government’s notice of deficiency (Final Partnership Administrative Adjustment (“FPAA”)) was upheld for the amount stated. The FPPA allowed only $42,400 out of a total $3,245,000 claimed as a charitable deduction on the partnership return of Boltar as the value of a conservation easement with respect to real property located in Indiana. The deficiency in the partners’ federal income tax resulting from the decision would approximate $1.12M (based on an assumed marginal income tax rate of 35% with respect to the disallowance of the excess deduction amount).

The Tax Court announced in Boltar, LLC, supra, that the standards of reliability and relevance (for admitting expert testimony) apply in trials without a jury, such as in the United States Tax Court, subject to the discretion of the trial judge to receive such evidence. In this case the Court ruled that the taxpayer’s experts failed to apply the correct legal standard in that there was no determination made of the value of the donated conservation easement before and after the valuation, the valuation failed to value contiguous parcels owned by the partnership and assumed development which was not feasible on the subject property.

It is noteworthy that there was no gross valuation misstatement or, alternatively, substantial valuation misstatement penalty, involved in this case. The penalty could have been 40% of the underlying deficiency based on the government's position on value. Indeed, no penalty was proposed in the FPAA. Fifteen months after the government’s answer to the petition was filed, 6 months after one continuance on respondent's motion, and 2-1/2 months before the next scheduled trial date, the respondent-IRS moved to amend the answer to assert a "pass-through penalty adjustment of $1,281,040". The Court granted the taxpayer’s move to strike the penalty on the basis that the motion was untimely and prejudicial. Thus, further cost and damage to the taxpayer’s filing position and failed expert testimony was avoided.

Background: Deduction for Value of Donation of a Conservation Easement

Section 170(a)(1) allows a taxpayer to deduct, in computing taxable income, and as subject to further limitations, the amount or value of a qualifying charitable contribution. Under Treas. Reg. Section 1.170A-1(c)(1), where a contribution is made is property other than money, the amount of the charitable deduction “is the fair market value of the property at the time of the contribution". Fair market value, as defined by the regulations, "is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts." Treas. Reg. Section 1.170A-1(c)(2). For partial interests in property, the deduction is the fair market value of such partial interest at the time of the contribution.

As is relevant to contributions of a perpetual conservation easement, Treas. Reg. Section 1.170A-14(h)(3)(i) provides that the value of the easement its is fair market value at the time of the contribution. Where a substantial record of sales of easements comparable to the donated easement (such as purchases pursuant to a governmental program) is present, the fair market value of the donated easement is based on the sales prices of such comparable easements. The regulations further explain that where no substantial record of market-place sales is available to use as a meaningful or valid comparison, as a general rule, the fair market value of a perpetual conservation restriction is equal to the difference between the fair market value of the property it encumbers before the granting of the restriction and the fair market value of the encumbered property after the granting of the restriction. See Hilborn v. Commissioner, 85 T.C. 677, 688-689 (1985). The “before and after” approach is used in various contexts in resolving certain types of tax disputes. See, e.g., Browning v. Commissioner, 109 T.C. 303, 311-316 (1997); Symington v. Commissioner, 87 T.C. 892, 894-895 (1986); Thayer v. Commissioner, T.C. Memo. 1977-370; S. Rept. 96-1007, at 14-15 (1980), 1980-2 C.B. 599, 606; Rev. Rul. 76-376, 1976-2 C.B. 53; Rev. Rul. 73-339, 1973-2 C.B. 68.

Expert Reports Filed By the Parties

As required in accordance with TC Rule 143(g), the parties exchanged their expert reports at pre-trial conference and were submitted to the Court. Rebuttal reports would soon be filed before trial again in accordance with Tax Court rules. The tax return (partnership informational return) for the year of the charitable donation claimed by Boltar, 2003 attached the appraisal report filed by its experts, who reviewed only a draft of the easement prior to issuing their appraisal on March 7, 2004 and did not rely on the final version of the recorded easement. The easement granted a Land Trust, Co., on December 29, 2003, to perpetually restrict the use of the subject 8 acres on the eastern side of a parcel (one of two) held by the partnership. The easement prevented any use of the property that would impair the conservation values of the property. Some of the factual nuances and details are set forth in the findings of fact made by the Court or as stipulated by the parties and are too lengthy to summarize in this post.

The taxpayer’s experts valued the subject property’s “highest and best use”, as either raw land or multi-family development, and arrived at the foregone use value by virtue of the easement at $3,245,000 leaving a residual value to the subject property of only $68,000. The deduction claimed by Boltar LLC for 2003 was based then on the multi-family development scenario. On the other hand, the government’s valuation expert stated that the value transferred (deductible) was only $42,400, and criticized the taxpayer’s expert report since it failed to determine the value of the restricted area both before and after the grant of the easement as required in the regulations to Section 170. The government’s expert valued the eased property strictly on permitted land use restrictions, i.e., single family residences.

In accordance with the Court's standing pretrial order and Rule 143(g), the parties exchanged and submitted expert reports. Petitioner's expert report consisted of the Integra appraisal and a transmittal letter to petitioner dated March 7, 2004, and a letter to petitioner's counsel dated April 15, 2010. In the letter dated April 15, 2010, the taxpayer’s experts addressed the views of the Internal Revenue Service valuation engineer (rebuttal report) but did not make any adjustments in their value opinion, maintaining that the amount determined in their 2004 appraisal was "supportable and appropriate.

Government’s Criticism of Taxpayer’s Expert Report

Prior to trial, the government filed a motion in limine arguing that the taxpayers’ appraisal was not reliable and was also irrelevant for several reasons: (i) the report did not include both a before and after value of the subject eased property as required in the regulations although the petitioner argued that such comparision had been done; (ii) the taxpayer’s report did not value all contiguous parcels it owned and encumbered by the conservation easement at issue in this case as required by regulation; and (iii) the 174 condominium unit development analysis used by the taxpayer’s expert included as part of an alternative scenario in the taxpayer’s experts’ report was not a permitted use on the eight acre subject property. The government contended that this hypothetical value on property that could not from a land use standpoint be converted into a 174 condominium unit project required that the taxpayer’s expert report be stricken. Indeed, this high-density potential (hypothetical) use caused the value “before” on the eased property to be substantially greater than the single family residential “highest and best” use scenario. The Court noted it would defer ruling on the motion in limine until all evidence was presented at trial. The Court deferred ruling on respondent's motion in limine because of the importance of the issues raised and the substantial effect on the case of eliminating petitioner's primary evidence. The taxpayer’s expert report was marked and the related testimony of petitioner's experts was heard solely as an offer of proof. Whether the report and testimony would ultimately be received into evidence and considered in determining fair market value of the easement depended, in the Court’s view, on application of principles expressed in Daubert v. Merrell Dow Pharm., Inc., supra, 509 U.S. at 591, as related to rules 702 and 703 of the Federal Rules of Evidence. The Tax Court ruled, as discussed herein, it was inadmissible.

Taxpayer’s Arguments for Admissibility of Its Expert’s Report

The valuation experts claimed that there was nothing wrong with including in the appraisal a hypothetical development project that could not fit on the land they purportedly valued, was not economically feasible to construct and would not be legally permissible to be built in the foreseeable future. As to the government’s invoking the Daubert rule, the taxpayer argued it is inapplicable in this instance since there is no jury in a Tax Court proceeding, and therefore TC Rule 143(g) requires that the report be received into evidence.

Federal Rule of Evidence 702

FREV 702 provides that where scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if: (i) the testimony is based upon sufficient facts or data, (ii) the testimony is the product of reliable principles and methods, and (iii) the witness has applied the principles and methods reliably to the facts of the case.

The Supreme Court in Daubert, supra, acknowledged that it is the trial court that serves as the “gatekeeper” as to what evidence is excluded as unreliable. See Kumho Tire Co. v. Carmichael, 526 U.S. 137, 148 (1999), the Supreme Court applied the same standard to expert testimony that was not "scientific". More importantly, the application of the Daubert rule is not limited only to jury trials.. See Atty. Gen. of Okla. v. Tyson Foods, Inc., 565 F.3d 769, 779 (10th Cir. 2009); Seaboard Lumber Co. v. United States, 308 F.3d 1283, 1302 (Fed. Cir. 2002) (standards of relevance and reliability must be met in bench trials). In any event, rule 702 of the Federal Rules of Evidence applies to bench trials as well as to jury trials and specifically sets forth applicable standards of reliability.

The Tax Court then stated that like other federal courts it too would strike the admission of unreliable evidence as a gatekeeper of the admissibility of expert reports as well. Laureys v. Commissioner, 92 T.C. 101, 127 (1989). The Tax Court further stated that an expert loses usefulness as well as credibility when giving testimony tainted by overzealous advocacy. Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980)(other citations omitted). Expert opinions that disregard relevant facts affecting valuation or exaggerate value to incredible levels are rejected. See Estate of Newhouse v. Commissioner, 94 T.C. 193, 244 (1990)(other citations omitted). The Tax Court, in an opinion written by Judge Cohen, stressed that the Court’s gatekeeper role in a non-jury trial enhances trial efficiency while at the same time making the fact finder more objective in reaching its final determination. It rejected being burdened by “ unreasonable, unreliable, and irrelevant expert testimony”.

At this point the opinion puts many tax professionals and valuation experts on notice. “ In addition, the cottage industry of experts who function primarily in the market for tax benefits should be discouraged. Each case, of course, will involve exercise of the discretion of the trial judge to admit or exclude evidence. In this case, in the view of the trial Judge, the expert report isso far beyond the realm of usefulness that admission is inappropriate and exclusion serves salutary purposes.” (emphasis added). This case therefore has wide-sweeping implications since valuation issues arise in many contexts in the Code, including federal estate and gift tax valuation disputes.

Here, the taxpayer’s experts failed to apply realistic or objective assumptions. One alternative determination of value reached by the taxpayer’s experts was based on raw land which supported only a modest or small deduction. Its alternative and yet unfeasible condominium use value supported the claimed deduction of $3,270,000 generating potential federal income tax savings in excess of $1.1 M. While making these alternative assumptions, the report fails to determine the highest and best use of the property after the easement is granted, it did not consider potential residential use of the property and thus did not value the property at its highest and best use after the easement was granted. From other evidence presented at trial, including the existing zoning ordinances and restrictions, the Tax Court noted that only single-family residential use was feasible (as an alternative to valuation as raw land) after the easement was granted and could have been developed within the conservation easement restrictions. Since the taxpayer’s experts made no attempt to determine the highest and best use of the property after the easement was granted by considering the potential for single-family residential development the report was stricken based on Daubert considerations and the deficiency om tax for the amount claimed by the Service upheld based on the value opined by the government’s experts.

The taxpayer also argued that the Service accepted the appraisal it filed as “qualified” under pertinent portions of the regulations and therefore the government should be estopped from denying such report's admissibility. The Tax Court quickly disposed of this argument by stating that an appraisal may be "qualified", i.e., sufficiently independent, for one purpose but lacking in evidentiary weight for another. See Section 170(f)(11)(E) (“qualified appraiser” requirement for substantiation of charitable contributions of property in excess of $500,000). See Evans v. Commissioner, T.C. Memo. 2010-207. TC Rule 143(a).

Therefore, the Court ruled that the taxpayer’s expert report was not the product of reliable methods and the appraisers did not apply reliable principles and methods reliably to the facts in the case. This is based on the finding that the report assumes scenarios that are unrealistic in view of the facts of the case and therefore are not relevant. It granted the government’s motion in limine and found the record in the case fully supported the government’s experts of the valuation (deduction amount) for the conservation easements. Indeed it had no other conclusion to reach on the record assuming that the government's expert report was admissible which it was.

Implications of The Tax Court's Boltar Decision

The Boltar case should be viewed as a “wake up” call to tax practitioners and estate planners that the Tax Court will throw out biased or improperly based expert reports when, as to the latter situation, it finds that the reports themselves lack foundation based on methodology or ignore the essential facts concerning the nature of the property that is the subject of the valuation dispute. Note again that the government was very late in asserting penalties be imposed in this case and therefore the taxpayer lost the case but was not penalized . Had such penalties been timely raised by the government the taxpayer may have had a most difficult time to overcome its burden of persuasion against an enhanced accuracy related penalty given the application of the Daubert principle by the Tax Court in this case. The penalty in this case could have been imposed for up to 40% of the underlying deficiency in tax. See Sections 6662(b)(3), 6662(b)(5), 6662(e), 6662(g) and 6662(h).